WARNING: Here Are 2 Metrics You Need to Know When Evaluating a Business

When you invest in businesses that grow their capital most efficiently, you will grow your wealth quickly. Return on Invested is the metric we use to determine how efficiently invested capital returns a profit. If a company invested $100,000 with $10,000 in profits, Return on Invested Capital is 10%. In this Article, we will discuss the 2 Sources of Capital in Return on Invested Capital, What is Return on Invested Capital, What is Return on Equity and Why Appreciation is a fool's game, and the Importance of the Return on Invested Capital & Return on Equity Ratios. By the end of this Article, you will become more proficient at finding more profitable businesses.

Two Sources of Return on Invested Capital

Return on Invested Capital is all the capital that goes into funding a business. There are two types of capital; debt and Equity. Debt is money that a lender loans to you with a specific interest rate with an agreement to pay back the entire loan within a specific time. The lender does not have any ownership of the business. He is merely letting you borrow money. IE: A bank will lend you $100,000 at %5 Interest for a 5-year term. Equity is money that has ownership in a business, whether it's your money or others' money. Each type of money has different interests and stipulations. Since there is no ownership, the lender requires a rate of return. Equity has ownership in a company through shares. These shares may or may now pay a dividend or return. Usually, well-established businesses with healthy cash flows will pay a dividend. Debt and Equity power a business, and without it, the business would go bankrupt. The next question is how effectively and efficiently a company creates profit from its Debt and Equity Capital. Return on Invested Capital tells us this.

What is Return on Invested Capital

Return on Invested Capital is the Return the Invested Debt & Equity yields from an investment. To run a business requires capital or Cash. As discussed above, the money can come from Equity or debt. When this capital enters a business, it goes to work to produce a profit. The question to ask yourself that all great investors ask is how efficient any business is at producing a profit off of the invested capital. The Return on Invested Capital ratio will tell you the health of a business. The ratio is Net Profit / Debt & Equity. The result shows how much net profit each dollar of capital produces. You can use this ratio to determine which businesses in an industry are most effective at producing profit from their invested capital.?

To dive deeper, the physical form of a business will tell you how efficient it will be at producing profit from invested capital. Commodity businesses like airlines, gas companies, oil companies, and similar companies are not efficient at creating earnings because most of the invested capital goes to operating the business, which leaves very little profit. Branded businesses like database businesses and social media companies spend much less money on expenses and reap enormous profits. Invested capital in these businesses works efficiently. Typically a commodity business or airline business will spend 90 cents of every dollar to run the company, and a database business will spend 60 cents on each dollar. That's a huge difference. Before you invest in any business, look at the ROIC of that business and compare it to other companies.??

What is Return on Equity?

After you have found a business with a solid return on invested capital, you should look at Return on Equity, which is how much profit each share produces. To calculate that number, divide Net Income / Total Shares. This ratio tells you how much net income each share makes. Return on Invested Capital and Return on Equity are ratios that show an investor how efficient the capital in a business is at returning a profit. These ratios are great for telling you how healthy a business is, yet they don't show how much your Equity returns if you invested in this business.

To calculate that number is simple and it requires investing in a dividend-producing company. I love dividend companies because they tell me that a company efficiently produces a profit and is willing to pay me if I give them some equity. Calculating your return on Equity requires adding up the quarterly dividends to find how much dividend payment yields per year. You can go to Yahoo Finance, which will do this calculation for you. Currently, most companies distribute 2% - 4% yields on each share which is a small return. Here is insider knowledge with Return on Equity. It will be higher if you own your own business with a similar Operating Margin. When you own and run your own business, you decide what to do with the cash flows. The owners choose how much to pay you from the cash flows when you invest in a business. When you own a business, you control the cash flows, and when you invest in a company, someone else controls the cash flows. You have two choices; either you own the cash flows, or someone else owns the cash flows and will give you a portion of those flows for your invested money. You can focus on both strategies by owning some businesses and investing in other companies. When investing in different companies, always look for Cash Flows from Operations and not Cash Flow from Financing. Cash Flows from Financing is where a company raises debt or Equity to fund its business. This funding source is a huge red flag.

If a company makes zero cash flows or loses money, the only way to increase your invested capital is through Appreciation, which is a bet that someone will pay a higher price for your shares or company. Over the long term betting on human behavior is a losing strategy because it's impossible to do. Receiving a return on your money through cash flow is a more effective strategy to create wealth, bringing us to our last point.

Why is ROIC and ROE Important?

These ratios tell us if a business produces positive cash flows. If you are an investor or entrepreneur, your wealth creation depends on how many Cash flows you own. It's similar to having a homestead property with fresh springs and plenty of fertile lands to grow food. You want land with as much of these two aspects as possible. The same is for cash flow. You want ownership in as many Cash flowing assets as possible. ROIC and ROE tell us how effective businesses are at producing profit. Profitable companies that pay you to own them are what make you wealthy. You only have a finite amount of currency or value. Place that value in the best vehicle that will grow it the quickest.